UK: Starting In Self-Employed Business

The Tax Consequences Introduction

Anyone setting up a new business will have a long list of
important matters to deal with (eg initial finance, premises,
insurance, stationery etc). Income tax and National Insurance
contributions may not be high on the list of priorities, although
attention to these matters at the outset could save time and
expense later.

Registering with HM Revenue and Customs (HMRC)

When you become self-employed you must register for income tax
and National Insurance purposes with HMRC. This can be done in one
of the following ways:

online;

by phoning the Newly Self Employed Helpline on 0845 915 4515;
or

by post using form CWF1 which can be downloaded from the HMRC
website.

In order to register you will need your National Insurance
number. In the case of a partnership all partners must register
separately. Further information is available on the HMRC
website.

When going though this process, it may also be necessary to
register with HMRC for VAT and/or as an employer obliged to operate
a Pay as You Earn (PAYE) scheme.

Anyone who becomes liable to pay Class 2 National Insurance
contributions (see below) is required to notify HMRC immediately. A
penalty may be charged if notice is not given by 31 January
following the end of the tax year in which the liability first
arose. In addition an individual is required to notify HMRC if they
have a liability to income tax or capital gains tax for any tax
year and this must be done before 6 October following the end of
the tax year in which the liability arose. Failure to notify can
result in a penalty.

Keeping records

The legislation requires businesses to keep minimum records as
set out on the HMRC website.

New businesses are recommended to seek advice on a suitable
bookkeeping system at the earliest opportunity.

Accounting periods

All the profits earned over the lifetime of the business will be
subjected to income tax although the timing of the assessments will
be affected by the accounting period chosen.

The profits and losses of a tax year will be based on the 12
month period used for the accounts. There are however special rules
applying in the first two and last tax years in business or if the
accounting date changes.

In the first year of business the profits taxable will be those
from the date the business started to the following 5 April.

For the second tax year, if the first accounting period is 12
months or more after the date the business started, the profits
taxed will be those of the 12 months to the accounting date. If the
accounting period is less than 12 months after the business started
it will be those of the 12 months beginning on the date the
business started. If there is no accounting date in that second
year, the profits taxed will be those of the 12 month period to the
5 April of that tax year.

Accounts prepared to 5 April or 31 March

Where a new business chooses an accounting date between 31 March
and 4 April the accounts for the opening years are treated, unless
elected otherwise, as though they were prepared to 5 April.

The taxable profits will be based on the actual profits earned
in the tax year so where a business starts on 1 October 2009 and
prepares annual accounts to 31 March thereafter, the 2009/10
taxable profit will be the actual profits for the period 1 October
2009 to 31 March 2010 and the 2010/11 taxable profits will be the
actual profits for the year ended 31 March 2011.

Accounts prepared to some other date

Assume new business started 1 May 2009 and accounts prepared to
30 April 2010. The assessment for the first year of trading
(2009/10) will be based on the time apportioned profits for the
period 1 May 2009 to 5 April 2010 - that is 11/12 of the full
year's profit to 30 April 2010. The 2010/11 assessment will be
based on the profit shown in the accounts for the year ended 30
April 2010.

Consequently the profit for the 11 months to 31 March 2010 will
be assessed twice and this double counting is recognised as
'overlap relief'.

On ceasing to trade in the future (or if you decide to change
your accounting year end at some stage) the taxable profit for the
final tax year, or the year of change of accounting date, will be
all the profits that have yet to be taxed, less any overlap relief
available. The overlap relief is not increased to take account of
inflation.

Tax payment dates

Under income tax self assessment, where payments are required
they will generally be due as follows:

first payment on account on 31 January in the tax year;

second payment on account on 31 July following the end of the
tax year;

any balance due or refundable on 31 January following the end
of the tax year.

An individual starting a new sole trader business may not
previously have received self assessment returns, but their
business involvement will result in HMRC including them in the self
assessment system.

Someone who started a new business on 1 October 2009 will have
an income tax liability payable on 31 January 2011 on the taxable
profit for the period from 1 October 2009 to 5 April 2010. On the
same day the first payment on account for the tax year 2010/11 will
be due. Consequently best advice is to provide for the eventual tax
liability on a current basis by putting funds in a separate
account. See HMRC website for ways of paying tax.

National Insurance contributions

A self-employed individual is required to pay Class 2
contributions (£2.40 per week for 2010/11). However a claim
for exception (using form CF10) may be made if profits are less
than the threshold (£5,075 pa for 2010/11). Class 2 NIC must
be paid direct to National Insurance Contributions Office (NICO)
and a direct debit arrangement can be set up.

Payment of this contribution secures entitlement to a range of
contributory benefits.

In addition individuals will be liable to pay Class 4
contributions (for 2010/11 these amount to 8% of profit between
£5,715 and £43,875, plus 1% of profits in excess of
£43,875). Class 4 NIC is collected as part of the income tax
self assessment. Class 4 contributions do not secure any additional
social security benefits and are effectively an additional income
tax.

Use of home

Where an individual uses part of their home for business
purposes for some or all of the time they will be entitled to claim
a reduction of part of the household expenses.

HMRC have set out their interpretation of this rule in their
Business Income Manual.

Sole trader/Partnership/Company?

Before trading commences advice should be taken regarding
whether to trade as a sole trader, in partnership, using a limited
liability partnership (LLP) or via a company.

The individual's tax position will depend on which vehicle
is chosen, but the decision should normally be made for commercial
reasons.

Trading as a sole trader is relatively simple, but the
individual will remain liable for all the business liabilities.

It is possible to start to trade in partnership with relatively
few formalities, but unless the terms are carefully defined by a
formal Partnership Agreement any disputes between the partners will
have to be settled in accordance with the Partnership Act 1890.
Each partner will be jointly and severally liable for the
partnership liabilities. For tax purposes a partnership is treated
as transparent and the taxable profits are allocated to the
individual partners according to their profit sharing ratios.

An LLP is a distinct legal entity and the personal liability of
the individual members for the LLP's obligations is limited.
For so long as the LLP is trading it is treated as transparent and
the taxable profits are allocated to the individual members.

A limited company is also a distinct legal entity and is liable
to corporation tax on its profits. Remuneration paid to the
directors will be an allowable deduction for the company and will
be taxed on the directors under the PAYE system.

Involvement of family members

Where members of the family are involved in the business then
they can be paid wages. Payment should be made separately from
usual housekeeping payments and the PAYE system will need to be
operated. Deductions against taxable profits for wage payments can
only be claimed for expenses which are wholly and exclusively
incurred for the purposes of the business and this means that the
wages paid must be justifiable in the context of the work done.
They also need to comply with national minimum wage rates.

Spouses and adult children could be involved in a partnership,
LLP or company. However there is antiavoidance legislation designed
to counter arrangements whereby one individual transfers a
"right to income" to another. The Government has been
considering ways of preventing income shifting between family
members that is not caught by the existing anti-avoidance.

IR35

Special rules apply where (i) an individual provides services to
an end-user through an intermediary (normally a partnership or a
company) and (ii) if those services had been supplied direct to the
end user the individual would have been regarded as an employee of
the end user.

Where the special rules apply to any particular engagement the
intermediary will effectively be liable to PAYE as if the earnings
had been paid as remuneration.

VAT registration

Where taxable supplies are being made, registration for VAT is
compulsory as soon as the value of supplies within the previous 12
months exceeds the threshold (£70,000 from 1 April 2010), or
it is thought that turnover may go over the threshold in the next
30 days.

To determine whether the VAT threshold is exceeded, the business
turnover for the previous 12 months should be calculated at each
month end and compared with the registration limit. The calculation
at the next month end excludes the first month of the previous 12
months' total, but includes the latest month's figure. If
the VAT registration threshold is exceeded at the end of say July
the business becomes liable to VAT one month later, ie with effect
from 1 September.

Voluntary registration may be requested by any business even if
the turnover does not exceed the VAT compulsory registration limit.
It may not be requested retrospectively.

Examples of when voluntary VAT registration might be appropriate
are:

where the nature of the trade is such that businesses within it
would normally be expected to be VAT registered (VAT voluntary
registration might give the illusion to third parties of a larger
organisation);

if all customers are VAT registered and could reclaim VAT
charged, a potential loss of recoverable input tax might arise if
the business is not VAT registered;

VAT input tax may be lost on assets or set up costs, but may be
recoverable if compulsory VAT registration eventually taken
up.

PAYE

Remuneration paid to employees will be subject to the PAYE
system. Normally an individual may earn up to the level of their
personal allowance (£6,475 for 2010/11) before having to pay
income tax, but there are National Insurance considerations, and
even if earnings are less than this threshold it may still be
necessary to notify HMRC that employment has commenced.

Since we have seen a focus and clamp down on tax avoidance/evasion and suggestions in the media that tax planning of any form is immoral if not illegal, some people have become nervous about taking any tax planning steps at all.

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